The Investor’s Scenario Surfer: Part Two — A Test Run of the New Portfolio Allocation Calculator

Note: Please see Part One of this article for background on the calculator and for a discussion of the first five years of results obtained in the test run.

Set forth below is a graphic showing my allocation choices and the results obtained for Years Six through Ten: You can click on the images to make them larger.

The P/E10 level stayed steady for these five years. That’s good. It’s important to keep in mind that steady valuation levels translate into annual returns of about 6 percent real. My portfolio value increased over the five-year time-period from a little over $130,000 to a little over $160,000. I am still ahead of all three rebalancing portfolios. But the 80 percent rebalancing portfolio is now offering the toughest competition.

This is the usual experience. As a general rule, 80 percent rebalancing beats 50 percent rebalancing, 50 percent rebalancing beats 20 percent rebalancing, and Valuation-Informed Indexing beats them all. This is because stocks are on average the best investment choice. The rule is — The more stocks you own, the better you will do except at times of high valuations. By protecting you from the downside of stocks at times of high valuations, Valuation-Informed Indexing gives you the best of all worlds — the high returns generally associated with stocks combined with greatly diminished risk of losses (substantial losses that remain in place for a long time are rare events starting from times of moderate or low prices).

The following graphic shows my choices and my returns for the next five years:

These were bad years for stocks. I show only a small gain for the five years. But in relative terms I am still doing well. Valuation-Informed Indexing is beating all three rebalancing strategies. If you follow informed investing strategies long enough, you will eventually end up with very big gains. No individual investor controls when those gains kick in. What we can control is our risk level. By lowering your stock allocations when the risk of big losses is greatest, you keep your personal risk level roughly constant while Mr. Market goes on one of his insane binges. By losing less in the price crash that inevitably follows a time of great overvaluation, you set yourself up for far bigger gains in the years following in which stocks are again available at reasonable prices. Each dollar that you protect in a price crash earns compounding returns for many years to come.

Now let’s look at my allocation choices for Years 16 through 20 and at the results achieved:

Prices are remaining low. Many of today’s investors cannot imagine valuation levels staying at fair value or below for 20 years. But it could happen! This return sequence is consistent with what we have seen in the historical record. Please understand that there re a large number of possible scenarios. You need to run the Scenario Surfer many times to gain a good sense of all the possibilities and of the odds of any of them turning up in the real world over the next three decades. Investors who came to believe during the bull market that we would never again see P;/E10 levels below 20 need to perform enough runs on the Surfer to leave them emotionally prepared for all possibilities.

The same general principles apply in all circumstances. You want to identify the value proposition offered by stocks (using The Stock-Return Predictor) each year and then set your allocation accordingly (taking your financial circumstances, your life goals, and your particular risk tolerance into consideration as well.

I increased my stock allocation to 90 percent when the P/E10 level dropped to 8.3. That is a very low valuation level, not much more than one-half of fair value. I left it at 90 percent in the following years because I aim to limit my allocation changes and the P/E10 level did not rise to dangerously high levels in any of the results that have yet turned up.

Here is what the next five years look like:

Please note that my edge over the rebalancing portfolios continues to grow, in part because I am going with a higher stock allocation (90 percent) than even the highest rebalancing portfolio. Am I gaining the extra return my taking on more risk? No! The Valuation-Informed Indexing portfolio is the far less risky portfolio. Please recall that I was going with a low stock allocation (30 percent) when the P/E10 level was 20. Going with a low stock allocation at times when the risk of investing in stocks is great permits me to go with a higher stock allocation when the risk of investing in stocks is limited while keeping my overall risk modest.

This graphic shows the approach to and arrival at the finish line of the 30-year return sequence examined in this run of the calculator:

These were a poor three decades of stock returns. We started at a high P/E10 level (20) and ended with a very low one (8.1). This is about as bad as it gets. Please don’t dismiss the possibility that we will see a return sequence much like this in the real world. We probably will not. There are many more appealing possibilities. But, if such a return sequence turns up, you need to know what to do to invest effectively given the realities that apply.

I believe that the Valuation-Informed Indexing strategy helped me do about as good as I could hope to do, given the circumstances. I beat the 80 percent rebalancing portfolio by only $63,000. I often see differentials far greater than that. It is not out of the question to see the Valuation-Informed Indexing portfolio come in at the end of 30 years at double the size of the best of the rebalancing portfolios. But in a return sequence like this one, in which exciting possibilities are unavailable to all investors, that $63,000 differential looms larger than it would in more inviting circumstances. If we see a scenario like this turn up in the real world, investors are going to be looking for whatever edges they can obtain. The new asset allocation strategy offers small edges where those are the best than can be hoped for and big edges in the different sorts of circumstances which of course we all hope will be the ones that will play out in real life.

To obtain the full benefit of The Investor’s Scenario Surfer, you need to perform multiple runs of the calculator. This is a training tool. Thinking about how best to respond to all of the possibilities that may play out over time trains you to be able to handle emotionally just about anything that Mr. Market happens